Gold has a very important place in Indian society and is consumed by even the poorer classes. It is held for the purpose of security as well as vanity. This point should be considered whenever we look at options for lowering demand for gold. These factors explain as to why Indias demand for gold kept increasing last year, even when the rupee had fallen by over 20%, which had pushed up the domestic price. Quite evidently, while we do look at ex-post factors that could have affected demand for gold like the underlying being a very good investment option, this could not be the driving force for such demand. Yes, there certainly is a class of people who buy gold for investment purpose, but they do not actually sell it when the price goes up--much like property, where individuals own multiple dwellings for creating assets that are rarely sold. If there is agreement on these factors, then some of the recommendations made by RBI can be examined.
RBI talks of gold deposits, accumulation and pension schemes. Will people really come forward and deposit their gold and take it back after say 5 or 10 years If it is held for security or vanity, then this will not happen. Also, most gold held by households could be in the form of jewellery and not coins especially in rural areas, which makes such a scheme a non-starter as the individual would expect the same to be returned at the end of the tenure. If the idea is to churn this gold for meeting further demand, then the scheme may not work.
Earning interest on such deposits can be a valid temptation. But then the problem rolls over to the banks. They can recycle the gold, if it is not jewellery. But then what about the price and exchange risk which will come into play at the time of maturity Also, in the terminal year, there could be a bunching of gold that will create problems for banks and the economy, as the country may have to import large quantities for paying back the deposit holders.
Banks have to necessarily hedge on futures exchanges to cover themselves, which involves a cost. If banks cannot participate in futures trading today, how will they cover themselves Therefore, any move to collect gold and recycle it will only mean deferring the problem for a future date even if the process works out. In fact, any sharp increase in the price of gold in international markets will cause a run on banks for return on gold deposits, which will not be very pleasant for them. Right now, the price is in the range of $1,700/ounce and the expectations are that it would move over towards the $2,000 mark depending on how long the dollar takes to stabilise given the current account deficit of the US. With an annual return of between 10-15% on gold, this may not be far off.
A way out is to dissuade the import of gold through higher tariffs or quantitative restrictions. The former is being contemplated; it worked in early 2012. Last year, the landed cost rose on account of both rupee depreciation as well as tariffs. Today, with the rupee largely stable between R53-55 per dollar, the exchange effect would be lower and a higher duty will be required to bring about any impact on demand. Quotas are outdated but could be more effective if we go back to the old license raj days. But any such restrictions bring in a black market which will also mean tightening up the forex regulations which have been opened up on the current account.
Another option is to encourage investors, who are buying physical gold, to go in for commodity futures because this way they can reap the benefits of gold price changes without going in for physical holdings. Exchanges like MCX and NCDEX offer such contracts, which can be provided with certain benefits such as trading charges to ensure that they become more attractive for investors. Contracts in longer tenures should be made liquid, as presently the main interest is in contracts up to three months. But what about ETFs They do physically hold on to gold that can be demanded by investors. Globally, too, ETFs have contributed to the demand for gold in recent years. Should we stop such funds from coming up This is a difficult question to answer in the present circumstances.
Gold loans are popular today among NBFCs. An idea that comes up is whether such loans should be done away with. If done, then holders will see less use of gold. Today, one invests in gold and takes a loan for liquidity knowing well that it can be gotten back with the investment value intact. In fact, with appreciation a near certainty in the medium run, the return of 15% per annum could well compensate for the cost of the loan being taken from the financial institution. Therefore, by not allowing finance against gold, the value could be dented. This is contrary to what RBI is espousing on encouraging such loans with prudential regulation to enable rural folk to get loans.
There are clearly few easy solutions here and higher tariffs appear the best way out, if it works. All other ideas appear to be fairly lengthy to work out and may not elicit the required response. Given its tradition value in Indian society, people will not willingly give up buying gold even when the price rises, which was evident last year. This is the real entrance to the maze.
The author is chief economist, CARE Ratings. Views are personal